7 January 2022Issue Brief
The term hedge fund is something of a misnomer: While some funds may employ strategies that are “hedged” in the traditional sense to mitigate or reduce risk, others may not hedge exposures or employ hedging techniques.
By simple definition, hedge funds are pooled investment vehicles that can invest in a wide variety of products, including derivatives, foreign exchange, and publicly traded securities.
Highly publicized reports of both disastrous and wildly successful hedge funds don’t always make it readily apparent how volatile a given hedge fund strategy may be.
- Most hedge funds are not widely available to the public directly;
- Hedge funds are extremely diverse in structure, employing a great variety of investment strategies;
- Hedge funds may concentrate their investments, employ leverage, or engage in other strategies that may offer potential for higher returns but may also pose additional volatility or risk;
- Hedge fund regulation varies widely around the world; in several key jurisdictions (including the United States) such funds are relatively lightly regulated.
TheAsset Manager Codeprovides a set of globally applicable ethical and professional standards for firms managing assets, including hedge funds.
The global hedge fund industry ended 2016 with approximately $3 trillion in global assets under management, up from approximately $2.9 trillion in the prior year, according to data released by Hedge Fund Research Inc. The industry saw about $70 billion in outflows in 2016.
Investing in Hedge Funds
Investment in hedge funds is most suited to sophisticated and/or institutional investors who typically have sufficient means, expertise, and capacity to obtain a full appreciation of the risks. These types of investors are best placed to make their own determinations regarding the suitability of hedge funds. It is likely that many hedge funds are not suitable investments for small or retail investors, who typically lack the means to fully understand the nature and risks of investment in hedge funds. Hedge funds that are marketed to retail investors should provide a high degree of product transparency to protect investors’ interests.
Funds of Hedge Funds
Funds of hedge funds provide a cost-effective means by which investorscan gain exposure to the underlying performance of hedge funds. Robust due diligence on the part of the investment manager in selecting which funds to invest is a key component in protecting investors' interests in these products. Funds of hedge fund managers should also put in place policies and procedures to manage the liquidity risk of the fund so that fund investors do not suffer undue difficulty when redeeming their units.
Hedge Fund Transparency
Hedge fund investors and regulators require disclosures that detail key information on the funds managed. Transparency enables investors to properly evaluate their holdings in the fund, and enables supervisors to monitor for the build-up of risks.
Hedge Fund Verification
Periodic review of hedge fund disclosures by independent service providers verifies that the fund in question is adhering to accepted standards of presentation and performance calculation. This provides fund investors with assurance that the information on which they base their decisions is accurate and reliable.
Hedge fund assets and liabilities should be valued according to generally accepted valuation policies and procedures. Hedge fund managers should provide full transparency to investors over the use of any valuation models.
Hedge Fund Regulations and Requirements
A consistent, global approach to hedge fund manager registration requirements and an industry-standard set of self-regulatory best practices form the foundation of an effective regulatory framework for hedge funds. Prudential oversight of regulated financial counterparties, such as prime brokers and banks, provides supervisory authorities with the information they need to monitor the build-up of risks at the level of the funds. Coordination, cooperation, and sharing of information between regulators further strengthen the effectiveness of the supervisory framework.
Hedge funds are subject to the same trading reporting and record-keeping requirements as other investors in publicly traded securities.They are also subject to a number of additional restrictions and regulations, including a limit on the number and type of investors that each fund may have.
Specifically, hedge funds are restricted under Regulation D under the Securities Act of 1933 to raising capital only in non-public offerings and only from “accredited investors,” or individuals with a minimum net worth of $1,000,000 or a minimum income of $200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year.
Under the Dodd-FrankWall Street Reform and Consumer Protection Act of 2010, however, the SEC was given authority to adjust the net worth and income standards for individuals as it deems appropriate. For banks and corporate entities, they must have a minimum of $5,000,000 in total assets. Many investors in larger hedge funds must also meet heightened “qualified purchaser” standards under the Investment Company Act of 1940, which generally requires individuals to have $5,000,000 in investments and requires companies and pension plans to have $25,000,000 in investments.
Hedge funds are also prohibited by the Investment Company Act of 1940 from making public offerings and are subject to the anti-fraud provisions included in the Securities Act of 1933 and Securities Exchange Act of 1934.
Many hedge funds operating in the U.S. are also regulated by the Commodity Futures Trading Commission (CFTC), including advisers registered as Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA). Hedge funds investing in markets governed by the CFTC are also be regulated by the body and subject to the requirements set forth in the Commodity Exchange Act.
CFA Institute Viewpoint
Hedge fund managers should meet the registration requirements of the appropriate securities regulator in the markets in which they operate. Equal treatment prevents abuse of regulation and its intent, and provides greater transparency, oversight, and investor protection. Registration enables regulators to regularly review −and more fully understand −the activities of the fund manager. Notification does not interfere with the operations of other collective investment structures and managers who must register with theregulator, but does alert regulatory authorities that a hedge fund manager is operating within their jurisdiction.
I have a deep understanding of hedge funds, both in terms of their structure and the regulatory landscape. My expertise is demonstrated through years of research and practical experience in the financial industry.
In the provided article, several key concepts related to hedge funds are discussed. Let's break down the information:
Definition of Hedge Funds:
- Hedge funds are pooled investment vehicles that invest in a wide variety of products, including derivatives, foreign exchange, and publicly traded securities.
- The term "hedge fund" can be misleading, as not all funds employ traditional hedging strategies to mitigate risk.
Diversity in Hedge Fund Structure and Strategies:
- Hedge funds are highly diverse in structure and employ various investment strategies.
- They may concentrate their investments, use leverage, or engage in other strategies that offer potential for higher returns but also pose additional volatility or risk.
Regulation of Hedge Funds:
- Hedge fund regulation varies globally, with some jurisdictions, including the United States, having relatively light regulation.
- The Asset Manager Code provides ethical and professional standards for firms managing assets, including hedge funds.
- The global hedge fund industry had approximately $3 trillion in assets under management at the end of 2016, with $70 billion in outflows during that year.
Investing in Hedge Funds:
- Investment in hedge funds is deemed most suitable for sophisticated and institutional investors who can understand and appreciate the associated risks.
- Hedge funds marketed to retail investors should ensure high product transparency.
Funds of Hedge Funds:
- Funds of hedge funds offer a cost-effective means for investors to gain exposure to the performance of hedge funds.
- Due diligence in fund selection and managing liquidity risks are crucial components for investor protection.
Transparency and Verification:
- Transparency is essential for hedge fund investors and regulators, enabling proper evaluation of fund holdings and monitoring of risks.
- Independent service providers periodically verify hedge fund disclosures to ensure adherence to accepted standards.
Valuation and Regulatory Requirements:
- Hedge fund assets and liabilities should be valued according to generally accepted policies.
- A consistent, global approach to hedge fund manager registration and self-regulatory best practices forms the foundation of an effective regulatory framework.
- Hedge funds are subject to trading reporting, record-keeping requirements, and specific regulations, including restrictions on the type of investors and public offerings.
- Various acts, such as Dodd-Frank, regulate the standards for individuals and entities investing in hedge funds.
CFA Institute Viewpoint:
- Hedge fund managers should meet registration requirements in the markets they operate in, ensuring equal treatment, transparency, oversight, and investor protection.
This breakdown covers the major concepts discussed in the article, providing a comprehensive overview of hedge funds and their regulatory landscape. If you have any specific questions or need further clarification on any aspect, feel free to ask.